MASTERCLASS Investing – How Return on Equity is used by investors and what does it mean?

MASTERCLASS Investing – How Return on Equity is used by investors and what does it mean?

Investing – How Return on Equity is used by investors and what does it mean?

Return on equity (ROE) is a ratio used by investors which expresses how much profit a company earned (or return) and compares that to the total shareholder equity. In basic terms, Shareholder equity is the total assets less total liabilities. It’s what the shareholders “own” and it is also comprised of the assets created by the retained earnings (profit, sometimes after dividends) of the business and the paid-in capital of the owners. Be aware what is used for the calculation, as there can be differences.

ROE is the amount of net income (company earnings or profit) achieved as a percentage of shareholders equity. It can also show a corporation’s profitability by telling us how much profit a company makes with the money shareholders have invested (equity).  Another name is “return on net worth” (RONW).
ROE is expressed as a percentage by the calculation:
Return on Equity = Net Income (Profit) /Shareholder’s Equity
As an example, if a company’s net worth (shareholder’s equity) is $250 million dollars and it produced $12.5 million in profit, it would be earning (return) 5% on your equity (ROE is $2.5 ÷ $250 = .05, or 5%).

A company manger’s goal is to achieve a higher “return” on your equity. Net income/profit is usually for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.
Why is it important?

ROE is an important measure for a company because it is ONE measure to compare the company profitability against oter companies. ROE measures performance and generally the higher the better. Some industries have a high ROE as they require little or no assets while others require large infrastructure before they generate profit, such as mining. For this reason ROE is even more useful when used to compare companies of the same industry

Performance ratios like ROE, are of course based on past performance but are used as an indicator on future performance.

A business that has a high return on equity is more likely to be able to generate cash and has less need for borrowings. The higher a company’s ROE compared to its industry, the better and the easier it is for the company to raise money for growth. When there is opportunity – taking on some debt, and managing it well, can be good for business growth.

Further good examples and comparisons of ROE of actual companies in USA can be found at http://www.buffettsecrets.com/return-on-equity.htm

Caution – Why one ratio and one year is not enough?

ROE from one year does not tell you enough. And as Conscious Investor and Stock Doctor can show the ROE over the years can vary. A consistent and steady ROE (and other ratios) is what is required).

A good point is made at http://www.fool.com/investing/beginning/return-on-equity-an-introduction.aspx  in the comments.

On March 23, 2010, at 3:51 AM, fdgxdfgxcf wrote: Roe is not as helpful as you think. It is easy to raise ROE with little effects on the valuation of a stock. Consider Netflix, a company who has a current ROE of 36. The extremely high PE was achieved by increasing long term debt by 200 million dollars and using the money borrowed to buy back 100 million dollars worth of stocks. By buying back stocks, the company reduces shareholder’s equity (the denominator), which ultimately increases the ROE. The current ratio will increase because of the extra 100 million dollars from the notes payable. The company seems stronger in the short term and more profitable when judged solely on return on equity. The bad news is that the company incurs a higher long term debt with more interest expense. To be fair to netflix, the stock was bought around $40 and is now close to $70. Management is praised as an efficient company, but a great extent of it is not due to actual net income but because of strategic accounting techniques.

See also what Professor John Price said about avoiding companies with low ROE

Want to learn the core issues of share investing? Our workshop Navigate to Successful Share Investing gives a 2.5 hour practical session to learn to easily understand Company Financial Statements, how to find healthy companies, what tools and ratios to use, work on examples, and also includes how to get better investment outcomes. Other Bonuses as well. Check the next one see Share WORKSHOP or call 0407 361 596

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